Buoyed by the strength of the long-term municipal market over the past 18 months, mutual fund assets have climbed to record levels, and portfolio managers have had little need to make major changes to their current investment strategies.

"At this point, we see little risk of rising rates given the sovereign conditions globally," said Gary Madich, chief investment officer for fixed income at JPMorgan Asset Management in Columbus, Ohio.

"We see the [Federal Reserve] on hold until late this year or early next year due to low inflation, improving - but weak - employment conditions, and weak housing markets," he said.

Madich said the firm avoids timing the market, instead employing strategies it believes will boost performance and act as a cushion against eventual rising rates.

"Longer-term, upward pressure on real rates seems likely given the growing indebtedness and an improving backdrop to economic conditions," he said.

With no immediate threat of a substantial rate hike on the horizon, some portfolio managers are focused on positioning their funds to perform well in the current low-rate environment.

Others are tweaking their game plans and exploring opportunities across the fixed-income market - both tax-exempt and taxable - that should pay off when rates eventually rise.

The chief options favored by some municipal managers are lower-rated general obligation bonds, high-grade securities maturing within two years, prerefunded bonds, daily and weekly floaters, and callable premium bonds.

Taxable managers, meanwhile, are increasing their funds' exposure to attractive corporate securities or are using inflation-oriented strategies, among other options, that offer income, diversity, and liquidity.

Municipal managers have had ample opportunities lately to shop as investors continue to pour record amounts of cash into the growing tax-free mutual fund industry.

Investors deposited cash into municipal mutual funds for 12 of the past 13 weeks, according to Lipper FMI, plunking down $612.5 million of new money during the week ended July 14. That came on the heels of the biggest influx of new money in four months, $676.1 million during the week ended July 7.

Meanwhile, inflows for 2010 exceed $20.7 billion, which combined with $15.2 billion in market gains has pushed the industry's assets to a record $502 billion for the first time ever, according to Lipper.

Mike Pietronico, chief investment officer at Miller Tabak Asset Management in New York, said he is using new cash to adjust the firm's muni portfolios. In order to perform in the historically low-rate climate, he is staying fully invested, neutral to benchmarks, and biased toward single-A rated tax-exempt GOs that offer extra yield and are attractive on risk-reward basis.

This stance, he said, will keep funds well-positioned until there is evidence of much higher core inflation, strong and steady job growth in the private sector, and a clear trend in deficit reduction for federal, state, and local governments - three key factors that he believes signal a bear market is imminent.

Pietronico looks forward to uncovering value - if and when rates rise - even if the opportunity is short-lived and yields soon ratchet back down as they typically do when demand spikes.

"We see any substantial back-up in rates as causing more of a buying frenzy as investors refrain from riskier investments, such as equities, until more clarity on the economic outlook is upon us," he said.

Miller Tabak is focused on increasing yield and income when possible, using diversification to create liquidity reserves, and employing shorter-duration strategies within its tax-exempt and taxable mutual funds.

"We will employ, in our broad market strategies, shorter duration securities, such as floating-rate bonds, to offer adjustments to market rates. In our more opportunistic strategies, we will use emerging market debt and senior bank loans for diversification and rate reset opportunities," Pietronico said. "Overall, we will take advantage of sectors that throw off monthly cash flows to allow for reinvestment at higher rates."

Madich said the firm avoids timing the market to capitalize on excessive returns for its $153.3 billion of fixed-income assets under management, of which $38 billion are municipal assets.

"During this type of environment, price discovery becomes very important ... and most of our products offer access to liquid bond sectors and strategies as a means to manage liquidity needs," he said. "We are discussing Fed exit strategies as part of our process, but see little risk of a less accommodative Fed in the very near term."

The Fed's stance has supported steady inflows into municipal mutual funds for nearly two years. This year's inflows are high, but below the $29 billion in the first half of 2009 and $40 billion in the second half, according to the Investment Company Institute.

Flows were positive for all of 2009 following a stream of outflows in late 2008. The industry has grown 47% since the end of 2008, according to Lipper.

The tax-exempt mutual fund industry's record inflow activity followed an unexpected drop in assets of $232.3 million during the week ended June 30 - only the third time since the end of 2008 that cash fled muni funds, after the weeks ending March 31 and April 14.

With outflows rare and little evidence that interest rates will rise beyond an occasional spike due to temporary volatility, other municipal managers are focusing on shortening duration and reducing price volatility with premium bonds.

They are also staying defensive with short and prerefunded securities to uncover value for their tax-exempt mutual funds, while also buying floating-rate paper for their tax-exempt money market funds.

John Mousseau, a managing director and portfolio manager at Cumberland Advisors in Vineland, N.J., said his firm is promoting strategies focused on mitigating investor fears about rising rates.

That hasn't been too difficult given the backdrop of low, real, after-tax rates on municipal bonds and expectations of continued low inflation over the next year, he said.

"We expect the Fed will be on hold with short-term rates at least through the balance of the year and possibly into mid-2011," Mousseau wrote in a recent report to clients.

Cumberland is reducing potential price volatility in its muni portfolios by holding on to existing callable bonds that were purchased in late 2008 and early 2009 that have coupons in the 5 1/2% to 6 1/4% range and have been trading as premium bonds for over a year.

This article orginally appeared in The Bond Buyer.

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